Chapter Six
6. Asset Valuation for Financial Reporting
Contents of chapter:
6.1.Basics of valuation
6.2. Overview of International Valuation Standards (IVS
6.3. Valuation approaches
6.3.1. Market approach
6.3.2. Income approach
6.3.3. Cost approach
6.4.Valuation report
6.1.Basics of valuation
Asset valuation is the process of determining the value of an asset, which could be a tangible
asset like a building or a piece of machinery, or an intangible asset like a patent or trademark.
The valuation is usually done by assessing a range of factors, such as the asset's condition,
market demand, supply and demand, current market conditions, future potential cash flows, and
more.
6.2.Overview of International Valuation Standards (IVS)
International Valuation Standards (IVS) are a set of globally recognized standards that provide
guidance on how to undertake and report valuations. IVS is developed by the International
Valuation Standards Council (IVSC), which is an independent, not-for-profit organization that
sets the standards for the valuation profession worldwide.
The purpose of IVS is to promote consistency and transparency in valuation practices across
different countries and markets. It covers a wide range of valuation areas, including real estate,
business, financial instruments, and intangible assets.
IVS is used by valuation professionals, regulators, investors, and other stakeholders to ensure
that valuations are conducted in a consistent and transparent manner. It helps to provide
confidence in the valuation process and the results that are produced.
Overall, IVS plays an important role in promoting trust and confidence in the global financial
markets by ensuring that valuations are conducted in a professional and Business valuation is
the process of estimating the value of a company or business entity.
The purpose of a business valuation can vary, from determining the value of a business for sale
or purchase, to determining the value for tax, legal, or accounting purposes.
The purpose of asset valuation can vary depending on the context.
For example, asset valuation may be necessary for:
Accounting purposes - to determine the fair value of an asset for financial reporting
purposes.
Investment analysis - to evaluate the potential profitability of an investment opportunity.
Taxation purposes - to determine the value of an asset for tax assessment or estate
planning.
Legal purposes - to determine the value of an asset in cases of divorce, bankruptcy, or
litigation.
Asset valuation methods can also vary based on the type of asset being valued. Common
methods include the income approach, the market approach, and the cost approach. These
methods often involve analyzing comparable transactions or market data, as well as assessing
the specific characteristics of the asset in question.
6.3.Valuation approaches
A valuation approach is the methodology used to determine the fair market value of a
business.The most common valuation approaches are:
6.3.1. Market approach
This method involves analyzing the prices of comparable assets in the market to determine
the value of an asset.
The analyst can use either data on publicly traded companies, or data on the sale of
comparable privately owned companies.
This method generally relies on pricing multiples, usually of revenue or some measure of
profit to arrive an indication of value.
This method is commonly used for valuing tangible assets, such as real estate.
Thus, the Market Approach relies on publicly available data for pricing data which can arise
from three primary sources:
Sales transactions of similar companies
Publicly-traded similar companies
Sales of interests in the subject entity
Notice that the first two sources rely on pricing data for other companies whereas the last
source relies on the subject company itself. Neither is a perfect apples-to-apples comparison
given the present day subject company will have unique qualities that are not necessarily
replicated in comparable companies or weren’t present in its prior stages.
Moreover, it’s possible that relying on more than one of these methods within the Market
Approach would result in a more accurate value for the subject company.
The following is an expanded version of the bulleted list that includes the widely accepted
industrynames for each of these methodologies:
Guideline Company Transaction Method – Sales transactions of similar companies
Guideline Public Company Method – Publicly-traded similar companies
Guideline Sales of Interests in Subject Company – Sales of interests in the subject entity
The Market Approach could be appropriate for a business when the following characteristics
are present:
The pricing data for comparable is robust and readily available
In situations where future cash flows are negative or highly unpredictable
Advantages
The Market Approach is “forward-looking” because market prices reflect investor
expectations about the future.
Assumptions, adjustments, and third-party data are required, but the overall analysis is
typically less complex than the Income Approach.
The value derived considers all of the operating assets, including tangible and intangible.
Insufficient or low-quality market data can limit the accuracy of the Market Approach or
render it unsuitable.
Key assumptions are often excluded; an example would be the growth expectations for the
comparable which can be available for public companies but rarely for private comparable.
6.3.2. Income approach
This method involves estimating the present value of the future income generated by an
asset. This method is often used to value income-generating assets, such as rental properties
or businesses.
Common methods within the income approach include the capitalization of earnings (or cash
flow)methodology and the discounted cash flow methodology.
The Income Approach could be appropriate for a business when the future cash flows have the
following characteristics:
Future cash flows are positive
Future cash flows are relatively stable – not highly volatile
Future cash flows can be reliably forecasted for several years into the future
Advantages
Focused on future cash flows which are of utmost importance to investors
Unlike the Market Approach, the Income Approach is not as reliant on similar past
transactions or comparable companies which can never truly match the unique
characteristics of the subject company
Unlike the Cost approach, the Income Approach considers value derived from both
tangible and intangible assets.
Not as relevant when valuing businesses that are years away from achieving positive cash
flow
Potential to become highly complex and involve many underlying assumptions
6.3.3. Cost approach
This method involves determining the value of an asset by estimating the cost to replace or
reproduce it. This method is commonly used for valuing tangible assets, such as buildings or
machinery.
The cost (or asset- based) approach derives value from the combined fair market value
(FMV) of the business’s netassets.
On the other hand, the asset-based approach usually ignores the value of intangible assets,
such as reputation, brand, customer relationships, and a well-trained workforce. As a
result, it frequently results in the lowest value of the three methods and may be used to set a
“floor” for thevalue of the business.
As previously discussed, the Cost Approach is typically used only in specific situations. Those may
include but are not limited to the following:
For use in valuations for financial and tax reporting purposes when minimal progress has
been made on a company’s business plan
For tangible asset-intensive businesses
For investment, holding, and real estate companies where cash-flowing operations tend to
contribute less of the value than the underlying assets
For small businesses where there is little or no goodwill
Advantages
Does not rely on the challenging process of forecasting future cash flows
Simple to understand and relatively straightforward to execute
Disadvantages
Rarely applicable to operating companies because an earnings-based approach is likely
more relevant
Does not directly value intangible assets so the valuation expert still needs to assess their
value separately or use an additional Cost Approach, such as a cost to recreate, to value the
intangible assets.
Discounted cash flow (DCF) analysis: This method involves estimating the future cash
flows that an asset will generate and then discounting those cash flows back to their present
value. This method is often used to value income-generating assets, such as businesses.
Option pricing models: This method is used to value assets that have uncertain future cash
flows, such as real options or financial derivatives. Option pricing models use mathematical
models to estimate the value of an asset based on the probabilities of different future outcomes.
Brand valuation: This method is used to value intangible assets such as brands, trademarks,
and patents. Brand valuation involves analyzing the financial and non-financial benefits that
the brand provides to the company, as well as its market position and reputation.
Importance of asset valuation:
Asset valuation is important for a variety of reasons, including:
[1] Financial reporting: Accurate asset valuation is necessary for financial reporting, as it
affects a company's balance sheet, income statement, and other financial statements. Proper
asset valuation ensures that financial statements are reliable and transparent.
[2] Investment decisions: Asset valuation is essential for making informed investment
decisions. Investors need to know the value of an asset in order to determine its potential
return on investment and to assess its risk.
[3] Mergers and acquisitions: Asset valuation plays a crucial role in mergers and
acquisitions. Valuing a company's assets is necessary to determine its overall value and to
negotiate a fair purchase price.
[4] Insurance coverage: Asset valuation is important for determining insurance coverage.
Accurate valuation ensures that assets are adequately covered in case of loss or damage.
[5] Taxation: Asset valuation is used in determining tax liability for both individuals and
businesses. Accurate valuation ensures that taxes are paid based on the true value of assets.
[6] Estate planning: Asset valuation is important for estate planning, as it helps individuals determine
the value of their assets and plan for their distributionafter death.
Overall, accurate asset valuation is crucial for making informed decisions and ensuring that financial
statements are accurate and reliable. It provides a foundation for sound financial management and helps
individuals and businesses achieve their financial goals.
The formula for asset valuation varies depending on the method being used. Here are
some common formulas for asset valuation methods:
Cost approach: Asset Value = Replacement Cost – Depreciation
Income approach: Asset Value = Present Value of Future Cash Flows
Market approach: Asset Value = Price of Comparable Assets in the Market
Discounted Cash Flow (DCF) Analysis: Asset Value = Present Value of Future Cash Flows-Discount Rate
Option Pricing Models: Asset Value = Probability-Weighted Future Cash Flows
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Example: An appraiser I valuing storage building that is 10,000 sqft with $25,000 in on site
upgrade. The property is 15 years old. The economic life for the building is 50 years and the
effective age of the building is 10 years old. The cost to build a new building is $100 per sqft. A
similar lot recently sold for $100,000 without the additional site improvements.
Required:
Using the cost approach calculate the value of the property rounded to the hundred dollars?
Given:
Building square footage = 10,000 sqft
Amount of upgrades = $25,000
Age of the property = 15 year
Economic Life (EL) = 50 years
Effective age of the building (EA) = 10 years
Cost to build new = $100 per sqft
Similar lot recently sold = $100,000
Solution:
Step 1: Calculate the cost of the new building
10,000 sqft X $100 per sqft = $1,000,000
Step 2: Calculate depreciation
$1,000,000/50 year (EL) X 10 years (EA) = $200,000
Step 3: Determine the estimated property value
$1,000,000 – ($200,000 + $100,000 + $25,000) = $925,000
6.4. Valuation report
A valuation report is a professional assessment of the market value of a property by a certified
valuer.
The report is based on the general condition of the home (observed via a visit), recent and
relevant sales history and other pertinent market data.
The property valuation report includes property information – rates, size of the land and
building, physical details on the construction and condition of the dwelling, details on any
immediate issues that may need addressing – as well as information on comparative sales in the
area.
